Monetary Policy Is A Bike Race, Not A Game Of Chicken

Joe Weisenthal

Nov. 5, 2009, 6:02 AM

It's easy to characterize monetary policy as a game of chicken.

Imagine Ben Bernanke driving in a car head on against ECB President Claude Trichet at 120 mph. Who will swerve first, tightening interest rates, and causing their currency to spike!? Who will hold bite their lip and hold out, keeping the pedal to the metal for the longest time, ensuring maximum stimulus? We'll find out.

But maybe that's a flawed games analogy.

Analysts at Morgan Stanley, in a new report, liken it to a peloton in a cycling race, where you've got the leader riders in the pack, willing to jump out in front of everyone else, and the rest of the pack, eager to draft off the lead riders, benefitting from decreased wind resistance.

At the front of the peloton… The front-riders - i.e., the early hikers like the BoI (Israel), Norges Bank (Norway) and the RBA (Australia) - have more flexibility right now. However, they face headwinds in their attempts to take away some of the monetary easing that is in place. First, risky assets are very strongly linked to their counterparts in the major economies, so that financial conditions will tighten less than they would have in other cycles. Second, concerns about currency appreciation and their impact on exports, particularly with global demand still weak, will also deter aggressive action. It is interesting to note that while these headwinds weaken the impact of policy tightening right now, the situation will be very different when the major central banks start their tightening campaign. Then, the headwinds to tightening could turn into tailwinds, which means that front-runners could find their financial conditions tightening without doing much policy-wise, which in turn could lead their currencies to weaken. Importantly, these headwinds to the front-riders are a direct result of the über-expansionary policy of the major central banks in the peloton.

So, who's drafting behind them?

However, not everyone is eager to get a head-start: Another group is eager to move firmly into the peloton to get the most out of the liquidity benefits of riding with the heavyweights. The central banks of Russia, Romania and Hungary have been cutting rates aggressively recently and are likely to continue to deliver more of the same (see page 20). Additionally, the RBNZ (New Zealand) in its last policy statement on October 29 went out of its way to make a rather unusual comment that markets were pricing in too many rate hikes. Effectively, the RBNZ cemented its place firmly in the peloton, content to get as much stimulus for its weak economy as it can, given its benign inflation outlook (see page 10). Finally, while markets have focused on the BoJ's phased removal of the corporate bond purchase programme as a sign of tightening, our Japan economics team points out that the more significant policy move on October 30 was actually a further easing via the unprecedented use of Fed-like commitments to "maintain the extremely accommodative financial environment for some time" (our italics). Given that the BoJ has a forecast of deflation for the next three years, our economics team suggests that further rate cuts or bond purchases should not be ruled out (see page 9).

As you can see above, the next round of leaders will likely include Canada, India, The Czech Republic, and Korea, followed later on by the EU, with the US only tightening later in 2010.